BDC Losses, MLPs And REITs – Slow Motion Melt

I previously worked for a white-shoe consulting company as their Director of Alternative Research. For sixteen years that company strove to produce unbiased manager selection choices, and were particularly well regarded for their alternative investment advice. Over a hundred different independent RIAs used this company as a backbone to their high-net-worth advisory businesses. It was a pure consulting model. No manager kick-backs were allowed to get on the approved list platform; there were no conflicts.

Then one day the firm was sold to a retail broker-dealer, and the business model started to change.

With new management soon calling the shots, the entire culture of the firm morphed into what I came to understand was more the norm in retail channels. Account wrap fees of 1% weren’t enough for these guys. They also strove to charge clients another 75 basis points for an active ETF sector-rotation model management program. The new group also only approved outside managers willing to kick back 35% of their fees to the broker-dealer. Some quality managers said “Thanks, but no thanks” to that type of deal. Others just paid the required baksheesh as a way to gain access to a retail distribution channel. But a negative selection bias certainly existed.

At the time, I looked at the CIO of this firm almost like a preacher standing on the pulpit dressed all in white espousing a “conflict-free” path to the promised land of investment riches. But at heart, he was a perpetually bullish ETF sector-rotation junky who had his hand out to get paid added big bucks if outside managers were to be allowed into his house of worship.

It all made me want to puke.

Worse yet, within a world of QE-induced ultra-low yields back in 2013, retail investors were clamoring for yield — any yield — and this firm’s retail brokers were all too happy to stretch the envelope to get there.

“Invest in a few non-traded REITs or Business Development Companies (BDCs),” would be the espoused advice. “If you’re willing to leave your money locked-up for five years, we can get you an attractive 10% yield from solid smaller company credits. If you want a bit more liquidity for a portion of your portfolio, add in a few exchange-traded MLPs.”

That sounded pretty nifty to many investors – at least at first.

That was before the MLP market cratered, and levered energy pipeline companies suddenly looked more suspect. If naive investors owned a diversified mix of MLP exposures within a portfolio such as Salient Mid-Stream & MLP Fund (SMM), they got their bit of carry, but also a great deal of portfolio angst.

BDC Losses, MLPs And REITs – Slow Motion Melt

That was before American Realty Capital Partners (ARCP) fell from grace within the REIT space with accounting irregularities, and commercial real estate more recently started to generally soften. Did investments like ARCP really just equate to its original ticker symbol re-jiggered: CRAP? New management was brought into that company last summer and wanted a fresh start with a new name: Vereit (VER). But so far, the name change and management change hasn’t helped the retail suckers very much.

And what did some of the BDCs do? Well, to get that promised 10% yield, many of these companies went out and bought the levered equity tranches of high yield CLOs. That puts them in the first loss position to almost get wiped out if just 10% of the underlying loans default without meaningful recoveries. At a recent annual investor conference recently held at the Waldorf Hotel in New York, an esteemed panel of credit hedge fund managers — including Marc Lasry of Avenue Capital and Steve Tananbaum of Golden Tree Asset Management — all basically agreed that defaults underlying high yield CLOs may eventually run around 20% of total current CLO holdings.

Those BDC holders aren’t going to be very happy. The problem is that while the pain of the MLP and REIT space is now relatively obvious, some of the BDC losses are still hiding unrealized. If a non-traded BDC was originally issued privately to a retail client at $10 per share, it may still be sitting on a retail customer account at the original $10 cost. Under current SEC rules (soon to be changed this April), the 7%+ front-end-load that the retail broker already received for selling clients some of these products may not even have been deducted from what appears on the client statement.

And many BDC companies (both private and public) appear to have little idea what the CLO tranches that they hold are actually worth, so they just leave them marked at their original cost, or very stale marks allowed by snoozy third-party pricing agencies. If you want a glimpse of CLO pricing disparities across one publicly traded BDC, readers should locate a copy of the research done by analyst Jonathan Bock at Wells Fargo. Within a January 2016 report, he showed pricing discrepancies of over 25% between some more honorable and realistic BDC shops and some other BDCs that have been slow at the switch to mark down their CLO structured product exposures. Prospect Capital is one company that he particularly warns against. Should investors sell the recent bounce? I would.

What is the end result here? The QE-induced grope for yield by investors has combined with brokers’ love of high front-end commission fees to destroy a great deal of retail wealth. But amazingly, some clients may not know it yet. They may consider that they own some quality high-yield loan portfolios in private BDCs that are doing just fine.

It is all what I call a “slow motion melt” of willful denial by both the product sponsors and the product owners. Both groups just want to avoid any bad news for as long as possible. If you don’t show the loss, maybe that loss will go away.

But if there is one message from the markets so far in 2016, it is that levered long credit can truly take a nasty bite out of one’s portfolio in the wrong environment. So too can Chief Investment Officers who act like holier-than-thou perpetual-bull-baby preachers with more of a concern for the commission revenue flowing into their pockets than actually protecting their clients.

The Fed wanted to create wealth with its QE policies, but with some help from Wall Street, they have instead helped foster much mal-investment. They have destroyed wealth. Tant pis. It should be better than this.

About David von Leib

David von Leib is a consultant within the asset management world who recently wrote Not My Grandfather’s Wall Street, a loosely-veiled historical fiction story set across various financial crises of the past 35 years. The book is available on Amazon.com.